Question

What are the rational and irrational reasons you think that may lead to high returns in small and value stocks? For rational reasons, think along the line of why these reasons matter in your real life rather than just being psychological

Answer 1

A description of stock where the underlying company has a small market capitalization, and whose stock price is currently trading at or lower than its book value. Finding a stock that fits both of these criteria is difficult, but it could be a worthwhile venture, because small-value stocks generally yield high returns.

The name can be somewhat misleading as these stocks are not of lesser value; "small" in this case simply refers to the size of the company.

According to Fama and French's three factor model, small-value stocks possess the two best qualities: size and value. According to the model, small cap stocks tend to outperform large cap stocks, because small stocks in general have a greater opportunity to grow compared to their larger counterparts.

In addition, value stocks generally have more upside potential compared to their growth stock counterparts, because growth stocks tend to already possess high valuations fueled by positive expectations for future growth. Therefore, it is difficult for such a stock to grow at this point in time compared to an undervalued counterpart.

Reasons that may lead the small and value stocks having a high yield -

1. The size effect -

Small-cap value stocks, by definition, represent smaller-than-average companies. Small is better (by and large) than big. And smaller is better than not-quite-so-small

everything else is equal, a portfolio with smaller companies should perform better, at least in a year like 2016 when small companies outperformed larger ones in general.

2. The value effect -  

Some companies have deeper value discounts (usually measured by the ratio of a stock price to the company's book value) than others. In a year like 2016 when value companies outshine growth stocks, deeper value (indicated by a lower ratio) should be an advantage.

3. Expenses -

When other things are equal, a fund with lower expenses will always have a greater return than one with higher expenses.

4. Portfolio turnover -

Beyond the operating expense ratio, fund investors also pay more when a fund buys and sells its companies more rapidly. Higher turnover, in other words, adds additional expenses.

This helps make the case for funds and ETFs that follow indexes. Actively managed small-cap value funds average turnover that's two to four times as high.

5. Number of holdings -

Holding more companies increases diversification and reduces risk. But sometimes that comes with a price

6. Sector exposure -

You could also categorize this one as luck, because various industries go in and out of favor from time to time.

7. Individual investors' timing -

This isn't really a trait of a fund. It's a trait of an investor.

If you bought a fund on the last trading day of 2015, made no changes through the year and sold it on the last trading day of 2016, your return should be the same as that of the fund. But this doesn't always happen.

If you waited until February or March to buy, or if you sold in October instead of holding until the end of the year, you missed a significant part of the fund's return.

Individual timing is usually detrimental to returns, because investors tend to buy when others are buying (hence prices are rising) and sell when others are selling (when prices are falling).

In real life,

Small-cap stocks are not tracked closely by market analysts and that is why the real value of good smallcap stocks can remain undiscovered for long. This makes investing in them risky. But the rewards of finding a hidden gem are huge too, for such a stock may become a midcap or even a large-cap stock over time, giving superlative returns.

Small-cap stocks are like trees that have just been planted. Obviously, they will take a few years to grow and blossom. They can be good bets for the long term On the flip side, small-cap stocks have a low equity base, which is why selling/buying can take time. If one buys a wrong stock, a prompt exit is difficult. Also, many small companies are young, with a very short track record. Hence, judging their performance is difficult.

Small companies are relatively weak in terms of governance, dividend policies and professionalism of the board. This makes them risky. When times are tough, large companies sail through, but the smaller ones are at the receiving end.

A high promoter stake shows his confidence in the business. You should also ask if the promoter plans to increase his stake. "One has to be extremely cautious while investing in smallcap companies. Attributes such as promoter holding, shares pledged, return on equity and debt-to-equity ratio should be considered carefully,"

A unique and robust business model augurs well for the company in the long run. If a small company is present in areas dominated by those with deep pockets, then chances are that it will close shop sooner than later.

Experts say institutions avoid buying shares of small companies due to lack of liquidity. But if you come across a small company in which institutions have bought stakes, you need to take the stock seriously. But be careful, as institutions can also take wrong calls